On Aug. 2, 2016, the Treasury Department and the Internal Revenue Service released proposed regulations under Internal Revenue Code (Code) section 2704 (the “Proposed Regulations”). The Proposed Regulations, if finalized in their proposed form, would eliminate most valuation discounts on redemptions and transfers of family business interests among family members when a single family “controls” the business both before and after the transfer.
Set forth below are summaries of the following:
- What Code section 2704 covers under current law.
- Some examples where the proposed, much-expanded coverage of Code section 2704 under the Proposed Regulations may be unenforceable.
- The process for comment, hearing and review before the Proposed Regulations are finalized and become effective.
- What family business owners should consider (from an estate planning perspective), given the scope of restrictions in the Proposed Regulations.
1. Scope of Code Section 2704 Under Current Law
Congress enacted “Chapter 14” (sections 2701 through 2704) of the Code back in 1990, to curb perceived abuses in the discounted valuation of property transfers between family members. In general terms, Code section 2704 addressed “certain lapsing rights and restrictions” affecting control of family businesses and/or rights to liquidate interests in family businesses.
NOTE: Under Code section 2704(d)(2), “members of the family” of any individual include (i) his/her spouse, (ii) any ancestor or lineal descendant of such individual or of his/her spouse, (iii) any sibling of such individual and (iv) any spouse of any person described in (ii) or (iii). Further, a business entity is “controlled” by members of a family if the members of a single family hold (a) at least 50 percent of the stock of a corporation (by vote or by value); or (b) at least 50 percent of the capital or profits interest in a partnership; or (c) any general partner interest in a limited partnership.
Code section 2704(a) addresses “lapsed voting or liquidation rights.” To date, these concepts have been interpreted as applying only in situations where a voting or liquidation right ceased to exist in the transferred property (i.e., actually lapsed). For example, the primary situation Code section 2704(a) was designed to remedy was the circumstance where a general partner in a limited partnership transferred his/her general partner (GP) interest to a child (or a trust for a child), and both by operation of law and under the terms of virtually every limited partnership agreement (LPA), the transferee became a limited partner (LP) or, in some cases, a mere assignee. That is, the control over the partnership associated with a GP interest ordinarily could not be transferred, only the equity associated with the GP interest could be transferred, and the act of transferring a GP interest had the effect of causing the control powers of the GP to lapse with respect to the transferred interest.
Thus, the proper and narrow application of Code section 2704(a) operated to disallow valuation discounts on transfers of property between family members only if and to the extent a voting right or liquidation right actually lapsed (ceased to exist) by reason of the transfer.
Similarly, Code section 2704(b) addresses so-called applicable restrictions that constrain a shareholder’s or partner’s ability to cause a liquidation of the business entity (i.e., the investor’s ability to realize the “net asset value” associated with that investor’s percentage equity interest in the entity by means of causing a liquidation of the entity itself). An “applicable restriction” is the functional equivalent of a “disregarded restriction” in the sense that an applicable restriction must be disregarded in determining the value of the transferred interest for federal transfer tax purposes. A restriction on the transferee’s ability to cause such an entity-level liquidation is an applicable/disregarded restriction only if and to the extent such restriction either (i) lapsed by reason of a family member’s transfer to such transferee, or (ii) could be removed by the transferor or any member of the transferor’s family (either alone or collectively) after such transfer.
- Proposed Expansions of the Scope of Code Section 2704 Under the Proposed Regulations
The Proposed Regulations would dramatically expand the applicability of Code section 2704, thereby preventing consideration of a substantial number of actual restrictions on business entity interests transferred between family members. In many instances, the practical effect of the Proposed Regulations would be the elimination (or substantial reduction) of minority-interest discounts and lack-of-marketability discounts for federal transfer tax purposes when the transferor and transferee are “family members.”
a. New Three-Year “Deemed Lapse” Rule
One major expansion (without any apparent statutory foundation) in the Proposed Regulations would be a new three-year rule for any gifts of equity interests between family members that effectively would cause the transferor to “lose” personal control of the enterprise. For example, suppose that an individual owns 100 percent of a corporation (Company A), and that individual gifts one-third of the equity in Company A to each of his/her three children, in equal thirds. It has long been accepted by the IRS that each 33.33 percent gift of equity interests was subject to a minority interest discount (because each donee had only one-third of the equity, so no single donee could exercise control). Further, under the current interpretation of Code section 2704, such a gift does not involve any lapse of rights with respect to Company A’s equity interests (because each donee’s 33.33 percent equity still has voting rights attached to it), nor are there any applicable restrictions on the equity interests that need to be disregarded because the equityholders, collectively, still have authority to liquidate the entity as the donor did prior to the gifts.
Under the proposed three-year rule, if (i) a “family,” collectively, has control of a business entity both before and after that individual gifts equity interests to or in trust for the benefit of members of such individual’s family, and (ii) the donor dies within three years after making the gift(s) that caused such individual to “lose” the personal legal control sufficient to cause the entity to liquidate, then (iii) the transferor’s inability to cause the liquidation of the business entity “caused” by the donor’s gifts will be treated (for estate tax purposes) as a “deemed lapse” of the liquidation rights held by the donor prior to the transfer(s), effective upon such donor’s death.
Thus, in the simple example above where a donor transferred 100 percent of his/her equity interests in Company A within three years of the donor’s death, the Proposed Regulations would include a “phantom asset” in the deceased donor’s estate. Even though there was never an actual lapse of any rights associated with the gifted equity interests, the Proposed Regulations would treat the deceased donor as if his/her “liquidation rights” in Company A lapsed at his/her death. Under that tenuous extension/interpretation of Code section 2704, the donor’s estate apparently would have to include (and be subject to estate tax on) the difference between (a) the date-of-death liquidation value of 100 percent of the stock in Company A (i.e., as if the decedent had held on to all of his/her stock until his/her death) and (b) the gift tax value of the three 33.33 percent minority-interest gifts donor made prior to (but within three years of) his/her death.
b. Under the Proposed Regulations, a Family Member May Be “Deemed” to Have the Ability to Force Liquidation of the Entity and/or to Force Redemption of the Family Member’s Equity Interest
Under a literal reading of the Proposed Regulations, if family members, collectively, could (i) vote to liquidate an entity (or to redeem the gifted interest in question) or (ii) vote to amend the documents governing the business entity (e.g., articles of organization, bylaws, shareholder agreements, partnership agreements or operating agreements) to allow the family to cause the entity to be liquidated (or to redeem the gifted interest in question), then any equity interest transferred between family members would be valued (for transfer tax purposes) as if the family member transferee could unilaterally compel either a liquidation of the entire entity or a redemption/liquidation of his/her own personal equity interest in the entity.
In other words, anytime an equity interest is transferred among family members in a business entity “controlled by” family members, the equity interest would be valued without regard to the actual economic fact that the donee-equityholder cannot compel liquidation or redemption of his/her gifted interest (much less, liquidation of the entire business enterprise). Thus, anytime an equity interest in a family-controlled entity was gifted, that equity interest, for transfer tax purposes, would be valued no lower than what the Proposed Regulations describe as the “minimum value,” conveniently defining minimum value to be the equity interest’s “share of the net value of the entity determined on the date of liquidation or redemption.” The Proposed Regulations would create an assumption that the donee-equityholder had the power to compel a liquidation of his/her interest in the entity at a price equal to the equityholder’s pro rata share of the net liquidation value of the enterprise on the date the interest was transferred by gift or inheritance to the donee, payable in six months.
It always has been a fundamental premise of corporate law that no individual shareholder ordinarily is able to compel a liquidation of the corporation or to compel a redemption of his/her own shares at any time. Similarly, in partnerships and limited liability companies and any other form of business enterprise (other than a sole proprietorship, where all decisions are made by only one person), no single equityholder can cause the business to terminate and be liquidated, nor can a single equityholder “force” the business entity to redeem that shareholder’s interest at “full liquidation value” (i.e., as if the entire enterprise sold all of its assets and distributed to that single equityholder an amount equal to an undiscounted percentage of that value corresponding to his/her percentage equity ownership in the business).
Consequently, one of the basic valuation discounts applied in connection with evaluating any equity interest in a closely held business enterprise has been the so-called closely held business discount or locked-in discount, reflecting the quite real economic fact that if an investor buys a noncontrolling interest in a business enterprise, that individual would not have any legal ability to compel a redemption or buyout of the investor’s equity in that business enterprise. The Proposed Regulations propose to adopt a rule in family-controlled business settings where it is “deemed” in all cases that the family would take steps to redeem any minority equityholder in the family, at full pro rata redemption value (i.e., as if all the assets of the business had been sold) at any time.
Such a rule would be both unfair and unrealistic. In the real world, no business could be operated if any and all equityholders, at any time, simply could demand “full fair value” redemption of their equity interests.
c. Disregarding Liquidation Restrictions Imposed by Federal or State Law
The Proposed Regulations also would disregard virtually all restrictions on liquidation of an entity that are “default” provisions under applicable state law (i.e., provisions that apply in the absence of an explicit agreement among the equityholders of the enterprise or an explicit term contained in articles of organization, bylaws or other documents setting forth governance rules for the enterprise). The Proposed Regulations would not permit state law restrictions (such as, for example, a state law rule requiring unanimous approval or a supermajority of equityholders to compel a liquidation of the business entity) unless such restrictions could not be changed or superseded by agreement among the equityholders or by the specific governing documents of the enterprise.
Thus, even though the statutory language of Code section 2704(b)(3)(B) (commonly referred to as the “state law exception”) indicates that restrictions on liquidation “imposed, or required to be imposed, by any Federal or State law” may be taken into account in determining the gift/estate tax value of a transferred interest in a business entity, the Proposed Regulations would permit consideration only of those state or federal law restrictions “required to be imposed” (in effect, reading out of the statute the words “imposed, or …”).
Such an interpretation of the state law exception under section 2704 would nullify the exception, since virtually no “default” restrictions on liquidation under federal or state law are “absolute.” The current, widely accepted interpretation of the state law exception makes much more sense: If a restriction on liquidation contained in the documents governing liquidation of a particular enterprise is no more restrictive than the “default” provisions of state or federal law, then such restriction may be taken into account in valuing an equity interest in that enterprise.
d. The Proposed Regulations Would Limit the Extent to Which Nonfamily Equityholders May Be Considered
The Proposed Regulations also include proposed restrictions on when nonfamily equity holdings may be taken into account in determining whether a single family has control of a business entity. Instead of considering the actual percentage of equity interests held by all nonfamily members in evaluating whether a family, collectively, controls the enterprise, the Proposed Regulations would disregard virtually all nonfamily equityholders by imposing arbitrary and unrealistic conditions on the recognition of nonfamily equity holdings.
As proposed, a nonfamily equityholder would be taken into account only if (i) the nonfamily member has held the equity interest for at least three years before the transfer at issue; (ii) on the date of the transfer, the nonfamily member holds at least a 10% equity interest in the enterprise; (iii) on the date of the transfer, nonfamily members, collectively, hold at least 20% of the equity interests in the enterprise; and (iv) each nonfamily member has a “put right” allowing such nonfamily member to force a redemption of his/her/its equity interest (with six months’ notice) at a value at least equal to such nonfamily member’s equity percentage multiplied by the full net asset value of the enterprise (i.e., a redemption at full liquidation value, without any discounts).
Interestingly, the three-year holding rule would mean that no nonfamily member equity interests could be taken into account in the first three years of an enterprise’s existence! If there is a concern that the nonfamily members’ interests were “illusory” on the date of transfer, why not test nonfamily ownership during the three years after a transfer is made? The 10 percent/20 percent equity ownership requirements appear to be arbitrary. The most impractical and unrealistic requirement is the put right that a nonfamily equityholder must have in order for his/her equity holding to “count.” Except in rare instances, such as partnerships that invest primarily in marketable securities, it would be difficult for a business or investment entity to grant any equityholder an absolute right to “put” his/her/its equity interest and demand a redemption with six months’ notice at full liquidation value. As a practical matter, by requiring that such a put right be granted to a nonfamily member before that nonfamily member’s equity interest is taken into account for purposes of determining family control of an enterprise, the Proposed Regulations would disregard virtually all nonfamily member equity interests.
e. Disregarding Redemption Values Reflected in Some Promissory Notes
One final expansive feature of the Proposed Regulations is the definition of “property” that the Regulations would consider as having been paid in redemption of an equityholder’s interest. In connection with redemptions of most closely held business interests (family-controlled or not), it is customary for a redemption to be paid in installments over a period of several years. Depending on the net cash flow available (and always subject to restrictions imposed by commercial lenders), it is not uncommon for the promissory note portion of any redemption price to be payable over a term of five to seven years (with the redeemed shareholder retaining a security interest in the equity being sold/redeemed).
The Proposed Regulations indicate that the portion of redemption proceeds payable in the form of “a note or other obligation” will not be considered “other property” being paid to a redeeming equityholder unless (i) the entity is engaged in an active trade or business; (ii) at least 60 percent of the value of the entity consists of “non-passive assets” of that trade or business; and (iii) only to the extent that the liquidation proceeds are not attributable to passive assets (within the meaning of Code section 6166(b)(9)(B)), “such note or other obligation is adequately secured, requires periodic payments on a non-deferred basis, is issued at market interest rates and has a fair market value on the date of liquidation or redemption equal to the liquidation proceeds.” (Emphasis added.)
The requirement of “market interest rates” is at odds with the custom and practice of issuing such notes at or slightly above the applicable federal rate (AFR) determined under Code section 7872. Since Code section 7872 was enacted (and operates) to create a bright-line threshold interest rate (the AFR) so that related-party notes and obligations that bear interest at or above the AFR generally do not result in gifts or in original-issue discount problems, why would the Proposed Regulations not permit notes or other obligations issued in connection with redemptions of equity interests to be issued at the AFR?
It is unclear how a taxpayer would demonstrate that a promissory note or other obligation “has a fair market value on the date of liquidation or redemption equal to the liquidation proceeds.” In this context, is the phrase “liquidation proceeds” supposed to mean the “face value” of the note or other obligation? Even if the note is “adequately secured,” it is common for such redemption notes to be assignable by the payee only with the consent of the redeeming business entity, and the mere fact that the payor is a closely held business arguably might be enough to cause the note to have a “fair market value” on the date of its issuance of “less than” its face value or the liquidation proceeds (whatever that would mean in this context).
f. Presuming Harmonious, Complete Family Control Is Unrealistic
A recurring assumption embedded in the Proposed Regulations is that a “family-controlled enterprise” will, in all circumstances, be operated so that any individual family member effectively will be able to convince the collective members of the family to exercise control in a manner that will allow that individual transferee (or, in some cases, the transferor, with respect to retained equity interests) to cause a redemption of his/her interest in the family-controlled enterprise at any time with a mere six months’ notice, and that the redemption would allow the family member to realize the equivalent of a full liquidation value (i.e., as if the entire enterprise were liquidated and the family member would receive his/her full pro rata share of those “deemed” full liquidation proceeds).
Such family harmony or commonality of purpose is often absent in family-owned enterprises. Rather than assume that all families operate their businesses without the conflict or contention found in many businesses, it would seem more realistic to consider whether any particular restriction on an individual equityholder’s powers to “liquefy” his/her interest and/or to compel a liquidation of the enterprise is consistent with the types of restrictions customarily employed in businesses that are not controlled by a single family.
Code section 2703(b) already contains a statutory standard that, until now, has provided taxpayers with fairly clear guidance on the types of agreements and restrictions on equityholders that should be recognizable for federal transfer tax purposes, especially in the context of restrictions on the circumstances under which an equityholder (family member or not) may “force” a redemption of his/her personal equity interest in the enterprise. The principles of the Section 2703(b) exception indicate that a restriction on a family member equityholder’s rights to use or sell his/her property interest will be respected (and taken into account when valuing such equityholder’s interest for transfer tax purposes) if the following standards are met:
(1) [Such restriction] is part of a bona fide business arrangement.
(2) [Such restriction] is not a device to transfer such property to members of the [transferor’s] family for less than full and adequate consideration in money or money’s worth.
(3) The terms [of such restriction] are comparable to similar arrangements entered into by persons in an arm’s-length transaction.
It is likely there would be years of ongoing taxpayer challenges to any Regulations that would seek to override the application of the 2703(b) exception and apply a new default set of rules for transfer tax valuations involving family-controlled business interests. To avoid a protracted period of uncertainty, this portion of the Proposed Regulations may well be withdrawn or further limited.
- Comments/Hearings and Effective Date Procedures Regarding the Proposed Regulations
The Notice of Proposed Regulations provides for a written comment period, followed by a public hearing in Washington, D.C., on Dec. 1, 2016. To be considered at the hearing, written comments must be submitted by Nov. 2, 2016.
Given the broad scope of the Proposed Regulations, and given the numerous new rules, restrictions and interpretations they would impose, it seems likely that the final version of the Regulations will be modified significantly. The Proposed Regulations will be commented upon (and likely criticized) by any number of groups representing taxpayers and tax professionals (such as the American Institute of Certified Public Accountants, the American Bar Association and the American College of Trust and Estate Counsel).
The preamble to the Proposed Regulations indicates that the proposed changes, as reflected in the final version of the Regulations, generally are proposed to apply (i) “to lapses of rights created on or after October 8, 1990,” and (ii) “to transfers of property subject to restrictions created on or after October 8, 1990,” in both cases “occurring on or after the date these regulations are published as final regulations.” The provisions of proposed new Regulation 25.2704-3, under which the newly defined concept of “disregarded restrictions” would apply in evaluating the rights of a family equityholder to have his/her/its own equity interest redeemed (i.e., without causing a liquidation of the entire business enterprise), are to be effective no earlier than 30 days after the final regulations are published.
As a practical matter, it seems likely that final regulations under Code section 2704 will not be issued until sometime in 2017, at the earliest.
- How Should Family Business Owners Plan Now?
The threat posed by the Proposed Regulations is considerable. If the regulations were to be finalized “as is,” the traditional valuation rules applicable for federal transfer tax purposes to equity interests transferred between family members would be dramatically changed. The level of discounts for lack of control, illiquidity and the closely held nature of equity interests all could be reduced artificially and severely.
Accordingly, the topic of business succession planning and potential wealth transfer planning with closely held business interests should be considered with renewed vigor over the balance of 2016 by any individual with an estate potentially subject to the federal estate tax. If a senior-generation family member is willing to consider transferring equity interests in a closely held enterprise this year, then the ideal approach would be to plan and execute such transfers before Dec. 1, so that the transfers would be complete before these Proposed Regulations become final.